Monte Carlo Analysis

Bringing Uncertainty and Risk Into Forecasting

Numerous chance events.

© iStockphoto/inkastudio

So you've created a carefully-researched cash flow forecast for the business you want to start. And it looks like it might be a flier.

But how good is this forecast really? Will you make exactly the revenue forecasted? Exactly? And in this world of wildly fluctuating commodity prices, will your inputs cost exactly what you've forecasted?

If your revenue is just a bit down on what you expect and your costs are just a bit higher, is your promising business actually more likely to be a loss-making disaster?

And what of other forecasts – production forecasts, population forecasts, economic forecasts, even weather forecasts? How do you bring the sheer randomness of everyday life into these?

One way of doing this quantitatively is with Monte Carlo Analysis, an important decision and risk analysis technique.

Understanding the Tool

The name "Monte Carlo Analysis" refers to the casinos at Monte Carlo in Monaco, where hundreds of chance events happen every day.

The idea behind the technique is that

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